1.4 Credit Risk Transfer Mechanisms Flashcards
Did the subprime CDO market play a central role in the 2007–2009 financial crisis?
False, the crisis was more about securitization process failures than the concept of credit risk transfer.
Who issues bond classes in a securitization?
The special purpose vehicle (SPV), not the loan originator.
Do credit default swaps (CDSs) transfer credit risk without impacting funding or relationships?
True, CDSs allow credit risk transfer without requiring funding or creditor participation.
Does the originate-to-distribute (OTD) model reduce loan originators’ incentive to monitor borrowers?
True, since loans are sold off, originators may not carefully underwrite or monitor them.
What percentage of total funding do equity tranches typically make up in a securitization?
Less than 10%.
Which financial instrument cannot transfer credit risk from a bank’s balance sheet?
U.S. government bond futures.
What additional risk did credit default swaps introduce to the financial system?
Counterparty credit risk.
What are the components of credit risk?
Default risk, rating upgrades/downgrades, and credit spread risk.
How do SEC risk retention provisions ensure banks have ‘skin in the game’?
By requiring securitizers to retain at least 5% of the credit risk without risk transfer.
What is the purpose of an SPV in securitization?
To issue bonds backed by loan pools, isolating risk from the loan originator.
How does the originate-to-distribute (OTD) model impact financial stability?
It reduces loan monitoring incentives, increasing systemic credit risk.
Why did regulators worry about the credit derivatives market before the 2007 crisis?
Few liquidity providers meant a high risk of systemic disruption if major participants failed.
Why don’t U.S. government bond futures help transfer credit risk?
They only hedge interest rate risk, not credit risk.
How do credit default swaps affect systemic financial risk?
They shift credit risk but create counterparty credit risk that can amplify systemic instability.
What role did equity tranches play in pre-crisis securitizations?
They absorbed initial losses but were often too small to prevent systemic problems.
